Contain This!

Contain This...We all know far too well by now that late last year
and early this year, many a Fed and Treasury official were proclaiming from
on high that sub-prime mortgage credit problems were contained. The party line
was that problems in that particular credit sector neck of the woods were not
about to spread or cause further problems in any other part of the domestic,
let alone, global credit markets. Riiiiiiiiight. Unfortunately for far too
many institutional credit market investors as of late, wrong. As you know,
we've been documenting and discussing this lack of containment issue for many
a moon, as well as factually documenting the fact that there is simply no way
the actual housing market is anywhere near a bottom, although it's certainly
continuing down that path as we speak. Time to move on to another very important
conceptual containment point of the moment. A new containment issue that we
believe will be very important for real world domestic economic outcomes ahead.

Let's start with a quick look at some longer-term housing data now updated
through the second quarter GDP report. We're looking at residential fixed investment
as a percentage of total GDP. As we've mentioned many a time, the most recent
had been the longest up cycle for residential investment on record. Hard to
imagine it would be all reconciled in a few quarters. And so far, it hasn't.
The down cycle has been playing out fast, exactly as had been the case in prior
cycles. It's certainly our belief that there is plenty more to come in terms
of southern exposure. At best, this measure of housing investment relative
to GDP bottoms somewhere near 3.5-4% of GDP. But given the extremes to the
upside in the prior cycle, our personal bet is something nearer 3%, or perhaps
just a touch lower. We'll just have to see how it all plays out.

But what is important to us, and hopefully you, at the current time is that
there sure as heck seems to be a growing chorus now singing yet another containment
tune whose lyrics extol the message that the housing industry specifically
is just not that big a part of the total US economy. Please remember that the
data above is only capturing the economic value of new construction in any
one period, relative to total GDP. It says nothing about the direction of prices,
inventory of homes for sale, etc. So yes, new construction of residential real
estate in any one period is not an end of the world number that alone will
determine the fate of the entire complexion of US GDP. But this is exactly
the data that many are pointing to and now suggesting that the influence of
the housing sector on the total economy is contained. "It's relatively small.
There is a much bigger world out there in the US economy than housing. It only
accounts for currently a little less 5% of total GDP. How in the world could
housing possibly throw the entire US economy into a potential recession?" You
know the tune, don't you? As you'll see in the chart above, we've overlaid
the year over year rate of change in nominal GDP. Directional correlation here
demands acknowledgment.

As you might imagine, we believe this new and quite convenient "containment" theory
of the moment is about as shortsighted as anything we've witnessed in a good
while. About as shortsighted as suggesting that mortgage credit problems would
be contained to sub prime credits only. The fact is that the influence of housing
in its entirety is incredibly meaningful to the totality of the US economy,
at least that's the message of historical experience. It's not just about new
construction, as you know. It's about leveraging the asset, it's about job
creation in finance, sales, construction, etc. It's about retail demand in
home improvement, remodel, etc. We don't need to go on and on, do we? We didn't
think so.

We'll make this quick as the message of the interrelationship between housing
and the broad economy is really contained (no pun intended) in the following
four charts that cover one heck of a lot of US GDP ground, if you ask us. In
fact the bulk of US GDP - consumption, manufacturing, employment and consumer
confidence. Influence these areas and you've taken a broad brush to the entire
domestic complexion of US GDP. So as you review all of the four charts below,
please look for and remember one meaningful item - in each case housing leads.
Yes, in every case. We're using the NAHB (National Association of Home Builders
Index) as a read on the character of housing, per se. Set against this are
payroll employment numbers, real personal consumption expenditures, industrial
production and consumer confidence. Broad enough for you? Again, in EACH case,
it's clear - housing leads. Let's start with payroll employment. Here you go.

We won't belabor the point as last month we published our September open access
discussion documenting the leading indicators of payroll employment (not including
this one) pointing downward. Turns out that was a week before the "surprising" decline
in August payrolls (that should not have been surprising at all). The above
chart just throws yet another log on an already open fire. The directional
lead and lag influence of housing on the direction of payroll employment is
self-obvious.

Next at bat is simply an update of a chart we've shown you in the past, just
more dramatic in its current message than has been the case for some time now.
And so housing doesn't affect consumer spending (PCE - personal consumption
expenditures)? Better think again. The correlation here is so high, even we
have a hard time believing it's this significant. It's just a good thing that
factual information leaves hope and personal opinion in a ditch by the side
of the road.

Here's one we have not shown you before, but it's high time right now. Housing
has no influence on the manufacturing side of the US economy, right? Wrong.
It's absolutely clear in this historical retrospective that peaks in the NAHB
survey have led the year over year directional change in US industrial production.
Same deal at cycle troughs - housing leads. Either the prior three housing
and industrial production cycles were complete flukes, or housing indeed impacts
the manufacturing side of the US economy. (Hint: It's the latter, trust us.)

Finally, the relationship between housing and consumer confidence. Since this
one is a bit of an intuitive lay up, we've left it for last. C'mon, how could
housing not have an influence on the consumer psyche, especially given the
very simple fact that housing is the largest household asset? Maybe the correct
question should be, how could it really be any other way?

The last time the NAHB survey was this low, consumer confidence was close
to half the level we see today. Any guesses as to which direction confidence
will be heading in the quarters to come?

So in quick fashion, there you have it. Personally, we've been hearing the "housing's
influence on the US economy is contained" investment rationalization far too
frequently as of late. We're sure you've been hearing the same. We did not
believe sub prime issues were contained when this little theory was being held
up as a reason for complacency, nor do we believe the reality and influence
of circumstances in the housing sector are contained relative to the direction
of the greater US economy looking ahead, quite the opposite. Again, point blank
- housing leads. Please don't forget just how important this is and the lessons
history has to teach us in the virtually incontrovertible data above. The next
time you hear the "housing is contained" argument, just remember the correct
response - Riiiiiiiight.

The Low Down...As we're sure you noted in the charts above, the NAHB
survey as of the latest reading is sitting at record lows for its two-plus
decade history. We must be near a very meaningful low for housing, no? That's
right, no. We're going to leave you with one last chart that may indeed be
one of THE most important data relationships of the moment. One of the reasons
we are so convinced that that there is much more to go on the downside for
housing, and why we're convinced no one should be underestimating the impact
of housing on the broader US economy of the moment, is price. Or more correctly,
lack of meaningful price reconciliation in residential real estate up to this
point that we believe is surely still to come. Below we're looking at the long-term
relationship between the median family home price and median family income.
Pretty darn simple stuff here. Level of housing prices to income. Can it get
any more basic than that?

Although this may sound like simple thinking, with all of the hoopla, sound,
fury and consternation over trying to "protect" homedebtors against potential
adverse mortgage credit issues, we believe the focus is completely incorrect.
As you know, both Bernanke and Paulson have been lobbying to allow Fannie and
Freddie to expand their balance sheets (lending), as well as raising conventional
mortgage loan limits. At least in our eyes, all of the proposed short term
band-aids or potential cures for mortgage credit problems de jour revolve around
expansion in lending. Of course, this has been the very problem horse that
has brought us to our current circumstances. As we look at the chart above,
the message seems as clear as a bell. The problem is that home prices still
remain too high relative to median household income levels. Of course the solution,
if you will, as per this diagnosis is to allow the housing cycle to play out
and existing home prices to decline to much more reasonable levels relative
to family income. After all, how can the problem for housing at the moment
(prior period excessive mortgage credit issuance) also be the solution (forward
excessive mortgage credit issuance?)? It can't.

The data used to construct the above chart tells us either one of two things
plays out dead ahead. Either housing prices fall relatively meaningfully from
here, or US domestic wages rise relatively meaningfully from here to get this
relationship closer to being in line with historical experience. Which do you
think will be the outcome ahead? If mortgage credit affordability is an issue,
can it really be that housing prices are not the issue? Of course not. Although
consumers have done a pretty good job hanging in there, so to speak, up until
now with housing prices softening over the prior year and one half plus, the
major test really lies ahead. At least since 1970, every single housing cycle
saw the median housing price to income ratio fall back to what we've calculated
as the average for the entire period shown. So this one will be different?
We beg to differ. If we had to guess, we'd say a trip in this ratio to the
350-375% level is an extremely reasonable expectation before the current cycle
has concluded, but we need to be prepared for reconciliation to go a whole
lot lower. That's another 10-15% decline in median family home prices from
here, at best. Can we suggest 2008 could be quite the interesting year for
housing prices in the US? Can we also suggest 2008 could be quite the interesting
year for the broader US economy? No wonder Bernanke chose to throw a 50 basis
point rate cut ball as the first pitch of the monetary inflation world series.

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